Will the Fed Go Too Far in This Cycle? 3 Indicators to Watch

Key Points

If the Federal Reserve raises interest rates too much or too fast, it could tip the economy into recession.

Signs that the Fed may be going too far too fast include a flat or inverted yield curve, a decline in inflation expectations, and tightening credit.

At this point, we see only one indicator—the flattening yield curve—that could be signaling an eventual end to the rate-tightening cycle.

There’s an old saying that when the Federal Reserve tightens policy, something breaks. That’s because rising interest rates expose borrowers who have taken on more debt than they can handle. In past tightening cycles, the Fed has sometimes gone too far, raising rates too much or too quickly, and ended up hastening an economic recession—however, the central bank’s overreach was apparent only in hindsight.

The Fed began raising its benchmark short-term interest rate in December 2015. Since the current tightening cycle began, the Fed has hiked seven times, bringing the federal funds rate target range to 2% to 2.25% as of September. The Fed’s “dot plot,” a projection that shows where each participant in the policymaking meeting thinks the federal funds rate should be at various points in the future, suggested in September that another hike is on the table this year and three more hikes are likely in 2019.

While it’s nearly impossible to tell in advance whether the Fed will go too far—that’s a question Fed policymakers themselves struggle with—there are a few things that historically have occurred as the Fed has reached the functional end of a tightening cycle. Keeping an eye on these market indicators may help investors gauge whether the Fed is near the end of the cycle or likely to overshoot, and whether it’s time to make portfolio changes to manage potential risk.

1. The yield curve flattens

Over time, as the Fed raises short-term rates, borrowing becomes more expensive and investors begin to expect slower economic growth in the future. That usually causes longer-term yields to decline. At some point, short- and long-term yields converge, and the yield curve¹—which normally curves upward—becomes flat, or even inverted (meaning short-term rates are higher than long-term rates). This convergence between short- and long-term rates historically has marked a peak in bond yields and a low point for bond prices (which move inversely to yields).

In past cycles, 10-year bond yields and the federal funds rate have peaked around the same level

So far in this cycle, the yield curve has already flattened significantly. The difference between the yield on a three-month Treasury bill and a 10-year Treasury bond has narrowed by about 115 basis points², from roughly 200 basis points in December 2015 to only 86 basis points at the end of September. Meanwhile, inflation expectations have been fairly steady, in the 2% to 2.5% region.

The yield difference between 3-month Treasury bills and 10-year Treasury bonds has narrowed

This means that, barring a sudden jump in economic growth or inflation expectations, it would only take two to three more 25-basis-point rate hikes by the Fed to cause short and long-term rates to converge.

2. Inflation expectations decline

As the Fed tightens monetary policy, making borrowing more expensive and slowing economic growth, investors’ expectations for future inflation usually soften. This can also be a sign that bond yields have peaked.

How can you tell whether inflation expectations have eased? One common method is to compare the yield of a Treasury Inflation-Protected Security (TIPS) with the yield of a comparable-maturity traditional (that is, non-inflation-protected) Treasury security. TIPS generally offer lower yields than Treasuries, because their coupon payments rise as inflation rises, while the principal value of a traditional Treasury is fixed. The difference between the two yields is called the breakeven rate, and is a key measure of what investors expect in terms of future inflation.

For example, if a 10-year Treasury offers a yield of 3% and a 10-year TIPS offers a yield of 1%, then the breakeven inflation rate is 2%. That is the average rate of inflation that investors expect to see during the next 10 years.

As you can see, the 10-year breakeven rate has trended sideways this year, and is currently just below its 2018 high of 2.18%. The most recent reading for the Consumer Price Index, in September, was 2.7%.

If inflation expectations begin to decline, it could be another signal that bond yields have peaked and the Fed should be near the end of its tightening cycle.

3. Credit conditions tighten

Another late-cycle phenomenon is tightening credit conditions—that is, loans become harder to get and more expensive. To date, there are few signs of tightening credit conditions. The yield spread between corporate bonds and Treasuries is relatively narrow, for both investment grade and sub-investment-grade borrowers, indicating that banks and investors aren’t very concerned about the risk of default. Also, the terms and conditions for sub-investment-grade borrowers are still easy. The Federal Reserve Bank of Chicago’s National Financial Conditions Index shows little sign of tightening credit conditions.

What happens if these signals occur?

High yield or riskier segments of the market have tended to underperform relative to higher-credit quality-bonds.

However, it’s important to note that if you wait for all of these signals to flash, there’s a good chance bond yields already will have begun to decline and riskier segments of the market may have begun to weaken. While keeping an eye out for a change in the market landscape, we also suggest considering the following actions:

Maintain short-to-intermediate term duration. With only one of the above indicators—the flattening yield curve—signaling a potential end to the rise in bond yields, we continue to suggest that investors maintain short to intermediate average duration (in general, that’s two to five years for corporate and Treasury bonds) in their fixed income portfolios, and consider floating rate notes as a way to increase income as short-term interest rates rise.

Put short-term performance in perspective. Despite the lackluster performance of the fixed income markets so far this year, overall returns for investors have been positive in every asset class since the Fed began raising interest rates in December 2015, as reflected in the chart below.

Since the Fed began raising rates in 2015, total returns for major fixed income indexes have been positive

Source: Bloomberg Barclays. Total return data for 12/14/2015 to 9/28/2018. Indexes are unmanaged, do not incur management fees and cannot be invested in directly. Cumulative returns assume reinvestment of income. Past performance is no guarantee of future results.

Stay invested. It’s tempting to try to time the interest rate cycle, but it’s not easy. There are ways to mitigate the risks we see on the horizon, but trying to catch the peak or trough in yields is very difficult. Staying invested and focusing on matching the duration of your bond investments to your investing time horizon and tolerance for risk still makes sense for most investors, whether interest rates are rising or falling.

¹ A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality but differing maturity dates.

² A basis point is one hundredth of one percent, or 0.01%.

What You Can Do Next

Make sure your portfolio is diversified and aligned with your risk tolerance and investment timeframe. Want to talk about your portfolio? Call a Schwab Fixed Income Specialist at 877-566-7982,visit a branch or find a consultant.

Important Disclosures:

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Diversification strategies do not ensure a profit and do not protect against losses in declining markets.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

International investments involve additional risks, which include differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

The Consumer Price Index (CPI) is published monthly by the U.S. Bureau of Labor Statistics. It measures the change in prices paid by consumers for goods and services.

The Chicago Fed’s National Financial Conditions Index (NFCI) provides a comprehensive weekly update on U.S. financial conditions in money markets, debt and equity markets and the traditional and “shadow” banking systems.

Tax-exempt bonds are not necessarily suitable for all investors. Information related to a security's tax-exempt status (federal and in-state) is obtained from third parties, and Schwab does not guarantee its accuracy. Tax-exempt income may be subject to the alternative minimum tax. Capital appreciation from bond funds and discounted bonds may be subject to state or local taxes. Capital gains are not exempt from federal income tax.

Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the U.S. government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.

Preferred securities are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features may affect yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so they are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors.

The Bloomberg Barclays U.S. Aggregate Bond Index is a market-value-weighted index of taxable investment-grade fixed-rate debt issues, including government, corporate, asset-backed, and mortgage backed securities, with maturities of one year or more.

The Bloomberg Barclays U.S. Treasury Index measures U.S. dollar-denominated, fixed-rate, nominal debt issued by the U.S. Treasury. Treasury bills are excluded by the maturity constraint, but are part of a separate Short Treasury Index. STRIPS are excluded from the index because their inclusion would result in double-counting.

The Bloomberg Barclays U.S. Treasury Inflation Protected Securities (TIPS) Index is a market value-weighted index that tracks inflation-protected securities issued by the U.S. Treasury. To prevent the erosion of purchasing power, TIPS are indexed to the non-seasonally adjusted Consumer Price Index for All Urban Consumers, or the CPI-U (CPI).

The Bloomberg Barclays U.S. Municipal Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed tax exempt bond market. The index includes state and local general obligation, revenue, insured and pre-refunded bonds.

The Bloomberg Barclays U.S. Corporate Bond Index covers the U.S. dollar (USD)-denominated investment-grade, fixed-rate, taxable corporate bond market. Securities are included if rated investment-grade (Baa3/BBB-/BBB-) or higher using the middle rating of Moody’s, S&P and Fitch ratings services.

The Bloomberg Barclays U.S. Corporate High-Yield Bond Index covers the USD-denominated, non-investment grade, fixed-rate, taxable corporate bond market. Securities are classified as high-yield if the middle rating of Moody’s, Fitch, and S&P is Ba1/BB+/BB+ or below.

Bloomberg Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The following indexes are a component of the Bloomberg Barclays U.S. Aggregate Index: Bloomberg Barclays U.S. Aggregate 1-3 Years Bond Total Return Index, Bloomberg Barclays U.S. Aggregate 5-7 Years Bond Total Return Index, Bloomberg Barclays U.S. Aggregate 10+ Years Bond Total Return Index.

Bloomberg Barclays U.S. Agency Index includes native currency agency debentures from issuers such as Fannie Mae, Freddie Mac, and Federal Home Loan Bank. It is a subcomponent of the Government-Related Index and the U.S. Government Index. The index includes callable and non-callable agency securities that are publicly issued by U.S. government agencies, quasi-federal corporations, and corporate or foreign debt guaranteed by the U.S. government (such as USAID securities).

Bloomberg Barclays Securitized Bond Total Return Index represents the securitized section of the Barclays US Aggregate.

S&P Bank Loan Total Return Index is a capitalization-weighted syndicated loan index based upon market weightings, spreads and interest payments. It covers the U.S. market back to 1997 and currently calculates on a daily basis.

BofA Merrill Lynch Preferred Stock Fixed Rate Index consists of fixed rate U.S. dollar denominated preferred securities and fixed-to-floating rate securities that are callable prior to the floating rate period and are at least one year from the start of the floating rate period.

Bloomberg Barclays International Developed Bond Total Return Index provides a broad-based measure of the global investment-grade fixed-rate debt markets. The three major components of this index are the U.S. Aggregate, the Pan-European Aggregate, and the Asian-Pacific Aggregate Indices. Bloomberg Barclays International Developed Bond Total Return Index ex US excludes the U.S. Aggregate component.

Source: Bloomberg Index Services Limited. BLOOMBERG® is a trademark and service mark of Bloomberg Finance L.P. and its affiliates (collectively “Bloomberg”). BARCLAYS® is a trademark and service mark of Barclays Bank Plc (collectively with its affiliates, “Barclays”), used under license. Bloomberg or Bloomberg’s licensors, including Barclays, own all proprietary rights in the Bloomberg Barclays Indices. Neither Bloomberg nor Barclays approves or endorses this material, or guarantees the accuracy or completeness of any information herein, or makes any warranty, express or implied, as to the results to be obtained therefrom and, to the maximum extent allowed by law, neither shall have any liability or responsibility for injury or damages arising in connection therewith.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

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